Amortizable Bond Premium
What Is an Amortizable Bond Premium?
The amortizable bond premium is a tax term that alludes to the excess price paid for a bond well beyond its face value. Contingent upon the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.
Grasping an Amortizable Bond Premium
A bond premium happens when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is over the face value amount.
The difference between the bond's current price (or carrying value) and the bond's face value is the premium of the bond. For instance, a bond that has a face value of $1,000 however is sold for $1,050 has a $50 premium. Over the long haul, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The progressive diminishing in the value of the bond is called amortization.
Cost Basis
For a bond investor, the premium paid for a bond addresses part of the cost basis of the bond, which is important for tax purposes. In the event that the bond pays taxable interest, the bondholder can decide to amortize the premium — that is, utilize a part of the premium to reduce the amount of interest income included for taxes.
The people who invest in taxable premium bonds ordinarily benefit from amortizing the premium, in light of the fact that the amount amortized can be utilized to offset the interest income from the bond. This, thus, will reduce the amount of taxable income the bond generates, and subsequently any income tax due on it also. The cost basis of the taxable bond is reduced by the amount of premium amortized every year.
In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Albeit this amortized amount isn't deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be utilized to amortize a bond premium consistently.
Amortizing Bond Premium With the Constant Yield Method
The steady yield method is utilized to determine the bond premium amortization for every accrual period. It amortizes a bond premium by increasing the adjusted basis by the yield at issuance and afterward deducting the coupon interest. Or on the other hand in formula form:
- Accrual = Purchase Basis x (YTM/Accrual periods each year) - Coupon Interest
The first step in computing the premium amortization is to determine the yield to maturity (YTM), which is the discount rate that likens the current value of all excess payments to be made on the bond to the basis in the bond.
For instance, consider an investor that purchased a bond for $10,150. The bond has a five-year maturity date and a par value of $10,000. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. How about we work out the amortization for the first period and second period.
The First Period
Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the subsequent period is the next six months, after which the investor gets the second coupon payment, etc. Since we're expecting a six-month accrual period, the yield and coupon rate will be separated by 2.
Following our model, the yield used to amortize the bond premium is 3.5%/2 = 1.75%, and the coupon payment per period is 5%/2 x $10,000 = $250. The amortization for period 1 is as per the following:
- Accrualperiod1 = ($10,150 x 1.75%) - $250
- Accrualperiod1 = $177.63 - $250
- Accrualperiod1 = - $72.38
The Second Period
The bond's basis for the subsequent period is the purchase price plus the accrual in the first period — that is, $10,150 - $72.38 = $10,077.62:
- Accrualperiod2 = ($10,077.62 x 1.75%) - $250
- Accrualperiod2 = $176.36 - $250
- Accrualperiod2 = - $73.64
For the excess eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), utilize a similar structure introduced above to compute the amortizable bond premium.
Characteristically, a bond purchased at a premium has a negative accrual; at the end of the day, the basis amortizes.
Features
- The premium paid for a bond addresses part of the cost basis of the bond, thus can be tax-deductible, at a rate spread out (amortized) over the bond's lifespan.
- A tax term, the amortizable bond premium alludes to the excess price (the premium) paid for a bond, far beyond its face value.
- The IRS expects that the consistent yield method be utilized to compute the amortizable bond premium consistently.
- Amortizing the premium can be worthwhile, since the tax deduction can offset any interest income the bond generates, consequently lessening an investor's taxable income overall.
